Protect yourself against exchange rate risk by investing globally

Readers who have been following me since the beginning of this blog know my paranoia about currency risk. No matter how good you select quality companies, if you don't take into account exchange rate effects, you risk seeing your income melt away like snow in the sun. Even securities listed on our domestic financial markets are subject to this risk, because of globalization. On the other hand, if you pay attention to this issue, you can take advantage of it by investing in companies that know how to make money from currency fluctuations.

The most beautiful companies of growing dividends located in the United States, With a dollar that is inherently weak, I have always been very attentive to the currency risk problem. All my investment strategies in dividends therefore take this problem into account, by first considering the volatility of investments not in their own currency, but in Swiss francs. Thus a stock that may seem a priori quite cushy in dollars may prove risky in CHF. Conversely, a US stock that fluctuates considerably in its currency may navigate calmer waters in Swiss francs.

Some securities also have a quality that is still little recognized among investors, that of freeing themselves from exchange rate risk. It is thus possible to invest in securities denominated in dollars without fear of devaluation due to the structural weakness of the greenback. This is particularly the case for companies that are very open to international markets and/or that work in the field of raw materials.

I have translated for you below an article that I found on gurufocus and which shares the same questions as my blog regarding the exchange rate risk. It is even surprising and instructive to read the point of view from the other side, that of the Americans, with their weak currency:

The first decade of the new millennium is now considered by investors to be a lost decade. They experienced two spectacular stock market crashes after the dot-com bubble of the 1990s and the housing bubble of the 2000s. Even with the US government’s use of money printing, the overall market return on investment, as measured by the S&P 500, has barely been positive since January 2000. If the picture is not so bleak in the US, ask the foreign investors who invested in the US market during this period. Since the last US budget surplus in the 2000s, the US dollar has lost value against major foreign currencies. An Australian investor who bought US$100 worth of Australian dollars in the early 2000s would have found himself with the equivalent of AU$62.10 in June 2011. While an American would have lost 13% on the S&P 500 during this period, an Australian investor would have suffered a loss of almost 50% on the same investment!

The situation is similar for investors from Japan, the Eurozone countries, Canada, Switzerland and even China. The Swiss investor is the one who has lost the most due to the extreme strength of the CHF. The situation is less problematic for British investors whose country faces a similar budget problem to the United States. 

What can investors take away from this? We should think more globally about our investment ideas. U.S. investors can even benefit from a weak dollar by investing in international companies.

It is certainly difficult to predict the movement of exchange rates. However, in the long run, countries with high growth rates and well-managed government spending translate into strong currencies. With a growing level of public debt and alarming federal spending, we know that the United States is not one of them. 

If you live in the US, you may not notice the weakness of the greenback. But you should be aware of this situation and protect yourself for the long term. How? Tom Gayner, CIO of Markel Corp (MKL), invests in US companies with large international operations. This is also the method of investor Arnold van den Berg, as he explains in our interview with him.

Maybe this is one of the reasons why Warren Buffett invested in international stocks, such as German reinsurer Munich Re, Swiss reinsurer Swiss Re, French pharmaceutical giant Sanofi-Aventis (SNY), British retailer Tesco (TSCDF.PK), Korean steel company Posco (PKX) and Chinese carmaker BYD (BYDDY.PK). 

When you invest in American companies that conduct a significant portion of their business abroad, revenue and earnings benefit from a weak dollar. This is particularly true of Coca-Cola (KO). In 2010, foreign currency exchange rates had a favourable impact on consolidated operating income of around 3 percent. Coca-Cola said the weak dollar helped its results. 

Johnson & Johnson (JNJ) generated total revenue of $61.6 billion in 2010, of which only $29.45 billion $ (48%) came from U.S. operations. Cigarette maker Philip Morris (PM), which is a spin-off of Altria (MO), has revenues of $67.7 billion $, of which $28 billion comes from the EU, $16 billion from Eastern Europe, the Middle East and Africa and $15 billion from Asia. Walmart (WMT) achieves approximately 26% of its turnover internationally, with approximately 20% of profits. 

US investors can therefore protect themselves against a decline in the dollar by investing in US companies that carry out large international transactions. In addition to this, US investors can also invest in foreign companies that are traded in the US through ADRs. This is Tom Russo's preferred investment method. Investors can buy these stocks just as they buy American companies. These foreign securities are tradable at the current exchange rate. A decline in the dollar therefore leads to an increase in the price, even if stock prices on foreign exchanges remain unchanged.

Tom Russo says, "70% of our fund is made up of foreign companies. These companies are generally family-owned and held for the long term. Their brands have hundreds of years of history. This gives them enormous competitive advantages. Their consumers are loyal." The fund's performance has benefited from the dollar's decline by at least 2% per year over the past 26 years. 

Let's take a look at one of his greatest hits, NestleThe food and beverage manufacturer is listed on the Swiss Stock Exchange under the symbol NESN. Its ADRs are traded in New York under the symbol NSRGY. While Nestlé is falling on the Swiss stock exchange, the ADR is rising in New York. The difference in performance comes from the devaluation of the US dollar against the Swiss franc. Another example is Japan. Toyota Motor Corp ADR (TM) rose while Tokyo shares stagnated. This came from a decline in the U.S. dollar against the Japanese yen.

Predicting short-term movements in exchange rates is as difficult as predicting tomorrow’s stock prices. But over the long term, a country that grows quickly and manages its government spending responsibly has stronger currencies. Investing in U.S. companies that do a lot of international business or buying ADRs of foreign companies can help diversify your risk and protect you against a weaker dollar. 

In my investment strategies, I pursue precisely the two axes described in this gurufocus article. Global Dividend Growers and Smoking & Drinking Dividends are composed predominantly of American companies that conduct a large portion of their business outside the United States. Ex-US International ETFs and Dividend Stocks are made up of non-US international companies.

I recently decided to supplement this last strategy with four new ETFs:

iShares Dow Jones Intl Select Div Idx (IDV) -NYSE Arca
WisdomTree Japan SmallCap Dividend (DFJ) -NYSEArca
iShares MSCI Switzerland Capped Index (EWL) -NYSEArca
iShares MSCI Japan Index (EWJ)-NYSEArca

These ETFs will soon be the subject of a more detailed respective article.